A slowing economy, crackdowns on shadow financing, and plummeting earnings from land sales are crimping China’s local governments’ spending power that could likely force them to slash their infrastructure spending, experts fear. But worse, after the property sector, investments in China’s infrastructure are seen as a potential second domino to fall, they say.
“[China’s] local governments are running increasingly higher deficits that will limit their ability to spend their way into growth,” Andrew Colliers, a China analyst and managing director at the Hong Kong-based Orient Capital Research, told The Epoch Times.
The central government, he added, has been cracking down on off-balance sheet or “shadow” financing due to concerns about financial risk, and the fact that that the property market is unlikely to rebound strongly (in near future), their revenue from land sales will be limited.
“Land sales alone are estimated to have funded 40 percent of their spending,” Gary Dugan, chief investment officer at Dalma Capital and a foreign investor in China, told The Epoch Times. “In the absence of a significant transfer of funding from central government to local government, China’s growth could stall.”
Although local governments have historically been a key driver of China’s economic expansion, this year’s weak growth, low tax revenue, and crippling COVID restrictions severely weakened their financial footing.
Yet, while the decline in state land sales revenue follows a nationwide crackdown on debt in the sector, risks of default are expanding as well for local government financing vehicles (LGFVs) and shadow banks since the property industry accounts for around 20–30 percent of the Chinese economy (including linked sectors).
Trust companies in China manage trust products for affluent individuals and small businesses, and the relationship between these three is mutually beneficial.
Chinese financial institutions provide loans to real estate developers, who typically lease or purchase land from municipal governments. Local governments utilize revenue from diverse sources, such as the sale of land, to fund infrastructure and public projects through LGFVs.
That aside, more financial hardship is on the horizon as local governments must make debt payments in the coming month, reducing their flexibility to comply with Beijing’s requirements to increase spending.
Many of them have already resorted to salary cuts, staff reductions, subsidy cuts, and even the imposition of unreasonably large fines to balance their budgets.
End of Land Finance Era?
For more than a decade, China’s authorities have been grappling with the dilemma of how to move domestic demand away from real estate without triggering a financial crisis or damaging to the economy.They believed they found a solution in 2020. The “three red lines” (financial regulatory guidelines) were supposed to carefully regulate developer leverage, and compel them to sell down their inventory (e.g., undeveloped land, projects under construction, and completed but unsold apartments), and stop utilizing pre-sales from one project to fund the start of their next.
But things didn’t go as planned. As Evergrande flirted with default in mid-2021, buyers became wary of buying pre-sold flats from other private developers.
Property sales plummeted, and more developers fell into financial difficulties, compounding the problem. But up until now, officials have been unable to break this cyclical pattern of failure, say analysts.
“Country Gardens was just one of many developers that hit hard times after a continued decline in sales in April,” wrote Adam Wolfe, emerging market economist at the London-based Absolute Strategy Research Ltd., in an exclusive client note accessed by The Epoch Times.
While the prospects for financial stability and the real economy could reverse eventually, he added, it is not going to be possible to shrink the real estate sector without also breaking the broader growth model that has underpinned China’s urbanization and industrialization for the past 20 years.
Economic Consequence
For the time being, though, local governments have been generating funding for infrastructure projects through special-purpose bond (SPBs), which are backed by the central government and have been a source of financing for several infrastructure projects.For instance, Mr. Dugan estimates that in the first seven months the total bond issuance was up 130 percent.
“As long as there is an investor appetite for the SPBs, the local authorities should be able to fund their infrastructure plans,” he said. “[But] the only concern is that some of the cash flow from SPBs has been directed towards propping up the financial sector that has been hit hard by the setback in the real estate sector. [Besides], much of the criticism of the infrastructure projects is whether they have been in the right sectors.”
Nevertheless, with many provinces facing higher debt pressures and refinancing risks due to their weakened fiscal conditions, and the central government introducing new rules and regulations, such as allowing swapping of their hidden debt into bonds, Mr. Wolfe believes infrastructure investment bond issuance will certainly crash.
“China’s policymakers are engaged in a daring high-wire act with a high probability of failure,” wrote Mr. Wolfe. “They’re attempting to dismantle the financing structures that have underpinned the country’s growth model for the past 20 years. Even if they succeed in the longer run, growth may slump toward 3 percent or less over the next few years as the land finance model collapses.”
